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Black Monday: The 1987 Market Crash Revisited

Exactly 25 years ago today the Dow Jones Industrial Average fell 22.6%. What came to be known as Black Monday was actually the culmination of a four-day slide of over 30%. In historical terms the one-day loss was the largest in history, far exceeding the 12.8% loss in The Great Crash of 1929.

Mass panics aren't triggered by single events. It takes a confluence of outside shocks and man-made idiocy to shave one-fifth off the market in a single day. The crash in 1987 wasn't something the market did to investors; traders and the government did it to themselves. In the attached clip I discuss what really drove Black Monday, with Eric Singer, author of the book Trade the Congressional Effect and Manager of Congressional Effect Funds.

The Three-Prong Attack on Market Bulls

1. Unintended Consequences of Populist Legislation

The 1980s were an era of the leveraged buyout. Corporate raiders would use relatively cheap junk bonds (now called "High Yield" bonds, to make them seem classy) to fund hostile takeovers. The additional leverage would inevitably lead to layoffs or flat-out liquidations of targeted companies — think Gordon Gekko's effort to chop up Blue Star Airlines.

In response, Singer says the House Ways and Means Committee "floated a trial balloon on making interest on junk bonds non-deductable to protect the management of large companies." In today's terms, DC tried to protect the 1% from the .01% by hiking taxes.

The instant the proposal hit the newswires, stocks thought to be takeover candidates collapsed.

2. James Baker Picks a Fight with Germany

The announcement of a larger-than-expected trade deficit came on October 14, 1987. In response, Treasury Secretary James Baker got tough with U.S. trading partners, specifically Germany. Baker's message, according to Singer, was "if you don't lower rates, we're going to lower the dollar and you're going to have export problems."

Getting tough with trading partners makes for a great soundbite in presidential debates. As the reaction in 1987 shows, actually threatening to start trade wars is less crowd-pleasing.

3. Portfolio Insurance

With the laws that were in place at the time, traders couldn't short individual securities without waiting for an uptick. Traders, being the same then as they are now, worked around the law with elaborate derivatives called portfolio insurance. The promise of these magical instruments was that they could perfectly hedge against losses by buying or selling options against real stock.

When things got ugly, stock sellers had to sell and options holders wouldn't. The disconnect between the two led to panic — which is complicated. Singer makes it simple. Portfolio insurance was simply "a precursor of what we're doing today with high-frequency trading."

Setting the Table for Another Black Monday

Today's version of taxing junk bonds is the proposed tax hike on dividends and capital gains. Hiking dividend taxes means every high yield stock on earth, all the "safety plays" that "pay you to wait," are significantly overvalued. At a 15% rate, a dividend of $4 is worth $3.40 after taxes. Hike that to 35% and a $4 dividend gets you $2.60.

Hike the dividend tax, and with a stroke of the pen every stock with a dividend would be worth less. Just like takeover plays in 1987.

In place of James Baker, we have both presidential candidates fighting over who can be "tougher on China." China is one of the few nations on earth willing to buy our wildly overvalued debt. Right now the Street thinks DC is bluffing on picking a fight with China, but they've got a hand on the equity eject button, just in case.

Finally, there's high-frequency trading. In the promise of risk-free, fast-moving immunity from normal market gyrations, HFT couldn't possibly be more like Portfolio Insurance. HFT magnifies moves in either direction. As evidenced by the 9% "Flash Crash" of 2010, when the HFTs start leaning the same way, things get very ugly, very fast.

We can't change the populist idiocy of DC, and staying tough with trading partners is always a careful dance. It's HFT where Singer says market cops can do the most to prevent another 1987. These "automatic pilot systems that can run away on us," if mixed with fundamental catalysts created by unwitting politicians and trigger-happy traders, can and inevitably will result in another 1987.

The real surprise is that it hasn't happened already.

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